I’d love to be able to report that Royal Bank of Scotland’s decision this week to raise £12bn in fresh capital is evidence that UK banks are finally accepting their share of responsibility for tackling the credit crisis. But sadly, that wouldn’t be true.
Put aside the idea that Royal Bank of Scotland’s move is part of some elaborate quid pro quo with the Treasury and Bank of England in return for their promise this week to pump £50bn into the UK banking system. It may suit Royal Bank of Scotland to present it this way, after months of insisting it didn’t need a rights issue, just as it suits the Bank and Treasury to come across all macho when public money is on the line.
But the reality is that only the Financial Services Authority can tell banks to raise fresh capital. And while it is undoubtedly true that the FSA has been stepping up its scrutiny of bank balance sheets over the last few months, it is also clear that most banks – including until very recently Royal Bank of Scotland – have equally robustly been resisting pressure to make them stronger.
What really seems to have swung the Royal Bank of Scotland board was the market’s reaction to a similar move by UBS earlier this month. UBS took more than $19bn in write-downs and launched a $15bn rights issue, yet its share price rose sharply. Investors could see what it needed to do, even if the board couldn’t. Having written down its assets aggressively to conservative valuations and shored up its own finances, the bank now looks able to weather the storm – something that didn’t look so certain a few weeks ago.
The same was true of Royal Bank of Scotland. The market could see the bank needed to raise equity and when the rights issue was announced, the shares duly rose. That’s important, because it has a bearing on what other UK banks may do. So far, they are all resisting pressure to raise fresh capital. Bradford & Bingley thought about it but decided against. Influential senior figures at Barclays are determined to tough things out. HBoS and Alliance & Leicester also insist they don’t need new capital.
With the Bank bailing them out with its new-found willingness to swap dodgy loans for government bonds, they are not in any danger of going bust as a result of a lack of access to funds. And all of these banks currently have better capital ratios – core shareholder equity as a proportion of total lending – than Royal Bank of Scotland.
But after the Royal Bank of Scotland rights issue, the pressure on the other banks to follow suit is now immense. Royal Bank of Scotland has set a new benchmark of around 6% core capital, which is higher than the other banks even before any significant writedowns. Other banks will now have to explain why they should not raise their core capital to similar levels. Plus, seeing how the market responded to the UBS and Royal Bank of Scotland rights issues, it will be harder to argue that holding out against a rights issue is what investors want.
In the short-term, therefore, UK bank shares look attractive. Although piling on fresh capital will inevitably reduce the return on equity, which might be expected to be a drag on the shares, the aggressive write-downs likely to accompany a rights issue will remove a major source of uncertainty over the stock. Investors will assume that all the current bad news is out of the way and that the bank will use the fresh capital for prudent – and profitable – lending, so the shares could be in for a similar pop.
But what about the longer term outlook for the banks? That is less certain. The reality is that almost all the writedowns we have seen so far relate to the value of securities, such as mortgage and credit card-backed bonds. These are loans that have been packaged up, sliced and diced and sold to investors. The banks’ holdings of these securities have been marked to market prices – and since markets are forward looking, that means a lot of expected bad news is in the price. But a much larger part of bank balance sheets relates to loans that have not been turned into securities – and these loans do not get marked to market prices, but are only written down as losses arise.
Since we are still only in the very early stages of the credit crunch as it relates to the real economy, the banks have yet to see much impairment to these loans. But that is sure to change as economic conditions continue to deteriorate. The question then is how far things will deteriorate, which in turn depends on how much the government and Bank of England is willing to do to prop up house prices. On the evidence of this week’s bailout, the answer seems to be not much – no doubt to the Government’s intense annoyance. The size of the bailout may be huge, but the terms were very tough – and rightly so. That suggests any bank share rally may prove short-lived.
Simon Nixon is executive editor of Breakingviews.com